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California's hedge fund king

Farallon sometimes make bad bets, of course. But with hedge funds imploding left and right, a look at Farallon's method show how the game is played when it's played shrewdly - this year's possible hiccup notwithstanding. What's more, depending on the November election, Steyer's days of obscurity could soon be over.

As a protégé of former Treasury Secretary Robert Rubin and an early Hillary Clinton supporter who stayed with her until the end, Steyer certainly would have been on the short list to succeed Hank Paulson at Treasury if Clinton had gone all the way. In an Obama administration, he'd be a long shot for the top fiscal policy job, but could still find a significant role. Rubin sees Steyer as someone who could make the rare shift from business to politics in the mode of a Michael Bloomberg. "He really has a strong sense of what the country ought to do," says Rubin, who is currently a director at Citibank (C, Fortune 500). Rubin invited Steyer into his public-policy clique, the Hamilton Project, sponsored by the Brookings Institution. The membership includes some of the left's leading financial minds including former Treasury Secretary Lawrence Summers. Steyer has fans on the other side of the aisle. Says Tom Lister, a Republican who heads the U.S. arm of European private equity firm Permira: "Just knowing that Tom Steyer could have been her Treasury Secretary would have been enough to make me vote for Hillary."

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Matthew Barger, a retired partner at the San Francisco buyout firm Hellman & Friedman, takes credit for convincing Tom Steyer to move to California - twice. The two were buddies on the Yale soccer team, roommates in New York City when they worked for Morgan Stanley out of school, and then again when Barger convinced Steyer to pass on Harvard Business School and attend Stanford with him instead. Barger, a California native, ended up working for Warren Hellman and Tully Friedman's private equity firm, and he urged them to hire Steyer, who in 1986 was a rising risk-arbitrage star at Goldman Sachs in New York under Rubin. "I told them you only run across a Tom Steyer once in a career," he says.

It helped that Steyer's soon-to-be wife wanted to move home to California. Steyer moved west, got married, and set up shop within Hellman & Friedman's offices as HFS Partners, with the mission to invest a small amount of H&F's money in the merger-arbitrage game. "I told him I didn't want him to get too large," says Hellman, still H&F's chairman and a dean of the San Francisco financial community. "I suggested $75 million; he said $100 million."

Together with a small team operating initially out of a single cramped office at H&F, Steyer did well, until the merger business collapsed in 1989. Decreased merger activity meant fewer opportunities to bet on the likelihood of deals closing, so Steyer had to find new investment ideas. It is a process he's gone through repeatedly since. He expanded his hedge fund's focus by hiring Moore, then a young bankruptcy expert. Her mission? Comb through the books of failed companies for opportunities to buy distressed debt. Following the S&L crisis, Farallon invested heavily in distressed real estate.

Today, there's a name for what Steyer was doing in the early '90s: multi-strategy. Vague though it sounds, it's not just throwing darts to choose an investment thesis. In Farallon's case it involves applying the same decision-making process to different areas of investment. Steyer, for example, had no background in real estate. From his risk-arb experience, however, he had faith in his ability to value the probabilities of expected returns and the paramount importance of estimating cash flows. By preaching these precepts placing bets only if a bottom-up analysis predicted acceptable returns adjusted for potential risk - Steyer could replicate his experience repeatedly in different sectors. In the Farallon model, relative value - what others are willing to pay for a security - is meaningless. In other words, the firm's approach is to calculate an expected return based on its analysis and have that - and only that - drive its valuation. Steyer's innovation was to apply what investors call "intrinsic value" to each new investment sector Farallon entered. "Tom hates to lose money," is how Katie Hall, Steyer's first partner at Farallon, describes Farallon's strategy. (Today, Hall runs a firm that manages money for wealthy individuals.)

For the benefit of its investors, Farallon compares its performance to the S&P 500 index. But beating a benchmark isn't the goal. Making money and, in a bear market, preserving capital are the objectives. After all, famous mutual fund manager Bill Miller, Legg Mason Value Trust chief, was praised for beating an index for 15 years - only to see his fund plunge more than 30% so far in 2008. Steyer's reputation is predicated on never having a year like that - with the understanding that investors also never will have an 500%-plus year like investors in one of John Paulson's funds did recently. His massive bet against subprime mortgages has made him the hedge fund star of the moment. "If somebody has good performance over three to five years, that's something, and people take notice," says Rubin, who is an advisor to Farallon. "After 22 years, that's something else altogether. It takes on statistical significance."

So where are Farallon's chips stacked now? The portfolio of public securities it discloses to the SEC is worth $8.9 billion - bigger than most hedge funds - and contains household names including Sherwin Williams (SHW, Fortune 500), Cablevision (CVC, Fortune 500), and Marriott International (MAR, Fortune 500). The fund's real estate interests include housing tracts picked up on the cheap from struggling homebuilder Centex earlier this year. Farallon also co-owns a collection of regional malls with Simon Property Group, which it bought in 2007 for nearly $8 billion.

Farallon is active abroad too, having opened its first international office in 1998. Today it has offices in Singapore, Hong Kong, Moscow, and London. Non-U.S. successes include the restructuring of Indonesia's largest bank; the funding of Indiabulls, a publicly traded real estate company in India; and most recently an investment in the second-largest coal company in Indonesia, Adaro, which went public this summer.

Farallon doesn't offer its investors the ability to bet on specific markets, though. Instead, all are getting a slice of the same investment pie, with Steyer playing the role of master asset allocator. There is no India Fund or Emerging Markets Commodities Fund, and that is a significant difference between Farallon and other supersized hedge funds like publicly traded GLG Partners, which manages multiple products, effectively pitting fund managers against each other for firm resources.

It's worth asking, of course, if Farallon is so good, why are its investments down this year? In his midyear report to investors, Steyer observes that valuations throughout the portfolio are declining, even for good companies. "We witnessed that almost across the board in the last few months," he writes. "For the long-term investor with dry powder and conviction, nothing could be better. The fact that, in the short term, undervalued assets can become even more undervalued frustates the short-term investor, however." Even longer-term, Farallon faces a bigger risk than current market conditions. Hedge fund watchers universally believe that mega-funds are increasingly stumbling over one another seeking out investments suitable for their size, and as these funds grow, the dynamic founders who built them get stretched too thin trying to cover the globe rather than exploit a familiar niche.